ESG rating market failure is more urgent than UK regulators know

The UK financial regulator – now scrutinising ESG ratings providers – must realise the stakes are much higher than exaggerated environmental claims for investment products, says Daniel Klier, CEO of ESG Book and former global head of sustainability at HSBC.

The UK’s financial watchdog has put ESG ratings providers on notice, threatening action against transparency failures “eroding” trust in the market. The main fear, it seems, is that opaque ratings are contributing to exaggerated environmental claims among investment products. They are, but the Financial Conduct Authority (FCA) must grasp that the stakes are so much higher.

The truth is that ESG scores have long resembled those for mortgage-backed security ratings that flooded the market in the run-up to the global financial crisis – not just because of the lack of transparency the FCA is railing against but because they are being interpreted as objective market signals and directing trillions in the capital, despite being riddled with subjectivity.

This time, broken ratings are not pushing us to the brink of a global economic meltdown, and it would be irresponsible to suggest so, but the ESG bull could soon morph into a bubble, threatening savings and investments globally.

And these deep-rooted problems with ESG ratings pose another risk. In the US, we’ve seen how some legitimate criticisms of ESG have been hijacked and repurposed by the growing ‘anti-woke’ culture war, fuelling a backlash that’s cost Blackrock alone $4 billion.

This is the beginning of something that could threaten the impact and performance benefits that ESG-done-right can achieve. And if the FCA doesn’t act fast, there’s no reason why politicians in the UK won’t be tempted by this ugly narrative themselves.

Fixing the ESG market failure

The FCA, at least, is aware there’s a serious problem. But the problem may be even more serious than they expect. So what do they need to do in order to fix this potential market failure? First of all, the FCA must force providers to be transparent with their methodologies.

Daniel Klier

Providers must be able to answer three questions: How have your scores been calculated? What is the data that underpins each score? Where does this data come from?

Subjectivity needs to be stripped from all methodologies, period. Without fulfilling these steps, scores have barely any more value than opinion-driven buy-and-sell tips published by financial commentators, yet they have the power to influence vast sums of capital.

The FCA must also encourage ratings agencies to involve companies in establishing a crucial feedback loop that eliminates confusion companies have with their own scores while giving them a chance to disclose their own data to fill in the blanks – of which there are many.

This is a crucial step that can’t be overlooked. ESG can’t be something that’s ‘done’ to companies with no power to engage. At the same time, bringing companies into the fold can incentivise them to disclose more non-financial data, which can only be a good thing for the markets.

ESG scores “ultimately useless”

And the FCA also needs to address the perception issue that is wreaking confusion across the industry. ESG is ultimately about measuring a company’s exposure to risk by examining the environmental, social and governance issues that are financially material to them. It’s not about who’s saving the planet.

ESG ratings providers are part of the problem. Because the reality is, if you asked them what the purpose of their scores is – for alpha, impact, or risk – they couldn’t tell you. And this ultimately renders scores useless and an amalgamation of different things that have little relation to each other.

The FCA’s intervention, while welcome, unfortunately, amounts to little more than a strongly worded letter at this stage. And while the regulator has indicated its willingness to take action, there’s no telling how long this will take.

In the meantime, technology is providing a solution. New scores, for example, are emerging that are transparent in methodology and source data and clear on their purpose. And platforms can now provide a space for companies to disclose ESG data easily, with direct impacts on scores.

But the presence of a technological solution can’t force the rest of the industry to change by itself, in the same way, that a plaster can’t replace a first aid kit. The FCA needs to act and act fast because the ESG ratings industry is resembling a crisis-in-waiting.

*Daniel Klier is former global head of sustainability at HSBC and now CEO of ESG Book.

© 2023 funds europe



The tension between urgency and inaction will continue to influence sustainability discussions in 2024, as reflected in the trends report from S&P Global.
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